How to Prepare for a Tax Audit

It's the last thing most people want to see at this tax-paying time of the year: a plain brown envelope marked "Official Government Business" with the return address of the Internal Revenue Service.

But don't panic. The news might not be as bad as you think.

While a full-blown tax audit might be your first thought, that notice might be the extent of your contact with the IRS. The agency might be telling you that you've made a math error on your return that must be fixed. Or maybe something on your W-2 doesn't agree with your tax return. In such correspondence-audit situations, you usually can clear up the discrepancy with a couple of exchanges of information via mail.

Then again, the worst could happen, and that envelope could be a notice that one of your past tax returns is being audited in full. In this case, what do you do?

Sharon Tabor Warren, an enrolled agent and author from Amherst County, Va., says, "If I have prepared the client's tax return for the year under audit, I ask them for an IRS power of attorney, Form 2848, and to forward their audit notice to me. Then, I tell them to sit back and relax -- I'll handle it from there."

This makes a good case for having a professional prepare your tax returns!

Warren says, "I never recommend that a client call the IRS themselves nor attend the audit. They can unwittingly reveal information that is not required and potentially cause more problems." A tax professional licensed to practice before the IRS can deal with the IRS and attend the audit for you.

Even with professional representation, you still must prepare for an audit by gathering information and taking it to your tax representative. As anyone who's gone through an audit can attest, the three top tips for preparing for the experience are good records, good records and more good records. In other words, adequate record keeping year round, not just on April 15, is essential in case of an audit.

More specifically, how should you, a taxpayer, prepare for an audit if it happens? These tips will point you in the right direction.

1. Retain the services of a professional. Enrolled agents, tax attorneys or CPAs may represent you at an audit. They are trained in tax law and can represent you much better than you can represent yourself. To a lay person, reading the tax code is like reading a foreign language. Enrolled agents have been around since the post-Civil War days and go through relatively grueling training in this very area.

2. Keep good records. It's not enough to just pull your records together year by year on April 15. Get in the habit of keeping good primary and secondary tax records year-round and using a personal filing system to keep them with the appropriate tax return. Then, if you're tapped for an audit, you're prepared. "It alleviates so much stress when you can put your finger on a document when you need it," says Allison Einbinder, owner of the tax and accounting firm Dollars & Sense in Oakland, Calif. Primary records are bills and receipts. Secondary records may be spreadsheets, mileage logs or other summary information you've kept. Warren recommends that you keep all tax returns, but that you keep your backup information for the current year plus three past years.

3. Gather information. What if you haven't kept good records for the tax year in question? Go back to that year and try to recreate records as accurately as possible. If you've claimed expenses in certain areas, like medical expenses, it's possible that your doctor or hospital will still have those medical records on file. Don't hesitate to call them. You can also call your place of employment and ask for duplicate W-2s or 1099 forms; or check with your mortgage company for interest expenses for that year; or with your county for personal property taxes paid. Put everything in a neat format, summarized but with supporting documentation, to take to the audit with you.

4. Do your homework. Einbinder suggests you research what the audit process is likely to entail. "Check with people in your industry or workplace to see if any of them have gone through the process," she says. "Find out what it was like so you can prepare yourself. You might be able to avoid some of the stresses they endured." Knowing what questions the IRS examiner might ask can also help lower the fear factor. The agency prepares audit guides for its examiners, with many of them posted on the IRS website. Check them out, says Einbinder, so you can go into the audit knowing, at least in part, what the auditor is going to ask.

5. Behave professionally. Generally, the IRS will set the time and place for an audit. Comply with their wishes if possible. If you or your tax representative cannot attend the audit at the time they set, negotiate another time with them. Remember that taxpayer presentation is critical. "Be polite, prompt and professional," says Einbinder. "It will get you so much further." Don't show up at the audit wearing jeans and with your receipts in a shoe box. Be on time, be organized and take the audit seriously.

6. Realize that the IRS auditor is not your friend. You can be sure of two things with an IRS auditor. First, he/she pays taxes. Second, there is an implicit assumption that you may have done something wrong, perhaps unwittingly, or you wouldn't be there in the first place. Be forthcoming with information, but only answer questions that are directed to you. Never volunteer extra information. Don't be surly or impatient, but also, don't be fearful. Be confident that your tax return was correct and that you have records to prove it.

The good news is that all audits do not result in the taxpayer owing extra taxes. There are many audits that prove the IRS actually owes you instead of the other way around.

You can help put yourself in that latter category by taking the steps outlined earlier. And if you have a complex return or if you're unsure about calculating deductions, seriously consider hiring a tax professional to prepare your return. It may pay off in the long run. The best defense, with regard to an IRS audit, is always a good offense.

For more information, read about the red flags that tempt tax auditors.